What are Penny Stocks? (4 Questions You Need to Ask Yourself)
Are you a ‘traditional’ investor looking to invest in penny stocks? Or perhaps you already have a few penny stocks in your portfolio and are looking to add more? Either way, this article is here to guide you. The below 4 penny stocks list of questions will help you in making the right investment decisions for your needs.
- What is a penny stock and how can I invest in them?
- What are the risks and rewards from investing in penny stocks?
- What criteria should I use to analyze penny stocks?
- How often should I be trading penny stocks?
1. What are penny stocks and how can I invest in them?
A penny stock is defined by the SEC as a publicly-traded stock that is valued at under $5 per share. In general, penny stocks are small companies with low market capitalization. While some penny stocks can be found on the major exchanges such as the NASDAQ, the vast majority of them are not traded on such exchanges. The following are the most common places to obtain penny stocks; note that you will have open a brokerage account first before you can start trading.
Formerly known as the NASDAQ SmallCap Market. Shares will typically be above $1. Probably the safest choice to obtain penny stocks due to higher compliance and regulatory reporting requirements. Stocks here will also be of higher information visibility as most financial news and quote services cover this board. Further, this increased visibility is a plus for trading volume and investor participation.
Formerly known as the American Stock Exchange. Stocks traded here have many of the same advantages as those on the NASDAQ Capital Market, except that they will typically have less trading volume. Another good choice to obtain penny stocks.
The Over-The-Counter Bulletin Board. Stocks that fall below $1 on the NASDAQ Capital Market are typically also moved to this board. Operated by the NASDAQ, it is a regulated quotation service (providing real time quote, price, and volume data) for over-the-counter (OTC) equity securities. Note that securities listed here are not subject to the same strict compliance and regulatory reporting requirements only requiring the filing of regularly updated financial reports.
Daily publications compiled by the National Quotation Bureau containing the bid and ask prices of OTC stocks. Compliance and regulatory reporting standards are practically non-existent. This is by far the riskiest method of obtaining penny stocks, next to buying it directly from the company (absolutely not recommended).
2. What are the risks and rewards from investing in penny stocks?
Penny stocks, due to their lower trading volume, are subject to extremely high volatility. This high volatility, while being a risk, also means the potential for huge returns to an investor, particularly if the company is on the verge of a breakthrough. In addition, because of low trading volume, even slight investor interest could potentially push the price up by many times. However, there are two other main risks associated with penny stocks, namely illiquidity and lack of information.
While volatility is both a risk and a reward, illiquidity is purely a risk. Investors who buy penny stocks may find it difficult to find willing buyers when they intend to sell the stock. The lack of information is related to the lower or non-existent regulatory reporting requirements on the OTC boards, which makes penny stocks subject to being used by unscrupulous people in order to scam the uninformed; this is why SEC regulations around penny stocks are focused on consumer protection.
To conclude, penny stocks offer the potential for very high returns, however all of its risks particularly those associated with illiquidity and the potential for fraudulent or misreported information. Due to its inherent riskiness, only investors with high risk tolerance should consider investing in penny stocks.
The following video encapsulates quite well on the inherent risks and rewards in investing in penny stocks.
3. What criteria should I be using to analyze penny stocks?
When analyzing penny stocks, we look at the following 4 factors:
Sector and Industry
Due to the aforementioned low trading volume and illiquidity of most penny stocks, it is generally unwise to short-term trade penny stocks. Hence, you want to look for a sector or industry that is currently on an uptrend in the market.
If a stock has recently been delisted (e.g. from the NASDAQ Capital Market to the OTC-BB), this is a sign that the company may face future difficulty in raising capital, which can be a warning sign. As previously mentioned, stocks listed on the NASDAQ Capital Market or the NYSE-MKT are the safest choice for penny stocks, so a delisting can be a red flag. You can check for any delistings on the SEC website.
You want to look at the company’s debt levels, cash reserves, asset values, and type of business. Some questions to ask yourself: Does this company have sufficient liquidity reserves to sustain daily operations? How does this company generate revenue? Is this sustainable? Can the company service its debt? (remember, as a penny stock, it would be difficult for the company to raise money via equity). You can obtain the relevant financial information from the SEC website or an online financial information provider.
Minimum Daily Volume
Low daily volume and illiquidity is the major risk for penny stocks. As a general rule, you would only want to look at penny stocks with a minimum daily volume of 100,000 shares. Anything under that puts you at a much higher risk of not being able to offload your shares later.
To summarize, we want to look at penny stocks which are part of an upward trending industry and have not been recently delisted from a major exchange. The company should have sustainable financial fundamentals and we should watch out for penny stocks which have a rising price and volume, which may be potential sign of an upward trend or even a possible price breakout.
4. How often should I be trading penny stocks?
There is no hard and fast rule when it comes to the correct frequency in trading penny stocks. There are some who trade penny stocks weekly or daily, considered more as ‘penny stock traders’ and yet there are those who may decide to hold on to a penny stock on a longer term basis, or ‘penny stock investors’.
In general however, due to the volatility of penny stocks and the tendency for even rising stocks to sell off (as mentioned in the above video), you should avoid getting greedy when the stock is on the rise and sell off quickly. Conversely, if a stock is on a downtrend, you should not get too attached to the stock and should sell if you feel that there are no ‘triggers’ that would cause the price to bounce back. Hence, whether you trade your penny stocks weekly, daily, or monthly would depend on the individual stock price movements itself.
In this article, we have taken a brief look at what are penny stocks and some of the boards and exchanges where you can find them. We then further broke down some of the risks and rewards associated with this type of investment as well as the four main criteria for analyzing said stocks. Finally, we looked at a common question on trading frequency of penny stocks.
We hope that you found this article informative and valuable; penny stock investing can be a great choice for the right type of investor and we wish you all the best on your investment journey!